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Ever since Warren Buffett acquired Burlington Northern Santa Fe (BNI), I have been keenly following the railroad sector in hopes of finding a quality company that could be a part of my long term portfolio. Railroads should be an attractive investment to most investors since the industry has high barriers to entry. This is slightly offset by the unionized nature of the business and competition from other modes of transportation (primarily the trucking industry). The U.S. railroad sector is dominated by four (4) companies namely Union Pacific (UP), Burlington Northern Santa Fe (BNI), CSX Corp (NYSE:CSX) and Norfolk Southern Corp (NYSE:NSC), while the Canadian market is controlled by Canadian National Railway (NYSE:CNI) and Canadian Pacific Railway (NYSE:CP).

Rail rates are generally cheaper than trucking rates and this difference in rates is expected to magnify with rising oil prices. According to the Association of American Railroads, adjusted for inflation, the average rail rates have in fact fallen 55% between 1981 and 2009. However, regulatory pressure might reduce this competitive advantage since government regulators have the authority to impose maximum allowable rail rates if a railroad has market dominance.

In this article, I will attempt to determine the fair value of the following major railroad companies: Canadian National Railway (CNI), Canadian Pacific Railway (CP) and Norfolk Southern Corp (NSC).

The financial and fundamental information for the companies mentioned above are shown in table that follows:

CNI

CP

NSC

Market Cap (Billions)

$31.05

$11.05

$22.89

TTM Sales

$7.39

$4.38

$8.84

Dividend Yield

1.53%

1.60%

2.3%

Operating Margin (TTM)

35.42%

21.99%

27.15%

Return on Equity (TTM)

19.13%

12.01%

12.06%

Return on Assets (TTM)

8.56%

4.72%

4.59%

Historical EPS Growth

11.84%

7.14%

3.62%

LT EPS Growth

9.73%

15.6%

12.61%

LT Debt to Equity

55.49%

69.28%

63.72%

Current Ratio

1.3

1.06

1.21

2010 EPS

$4.14

$3.73

$3.89

2010 Sales/Share

$17.76

$29.42

$25.92

Book Value (MRQ)

$24.60

$28.31

$29.43

Relative Valuation

Relative valuation was performed based on historical ratios of the company and its peers. Adjustments were made to account for outliers present in the dataset. The current P/E, P/S and P/B ratios were compared to the corresponding ratios of peer companies and an estimate for the respective ratios was obtained. Fair value was calculated by applying these estimates to 2010 EPS, sales per share and book value.

CNI

CP

NSC

P/E

Current

15.53

16.39

18.4

Estimate

18.15

15.50

18.88

Fair Value

$75.13

$57.82

$73.44

P/S

Current

4.09

2.47

2.57

Estimate

3.33

2.06

2.42

Fair Value

$59.12

$60.46

$62.84

P/B

MRQ

2.73

2.31

2.11

Estimate

2.53

1.74

2.25

Fair Value

$62.28

$49.18

$66.28

Avg FV

$65.51

$55.82

$67.52

Discounted Cash Flow Valuation

DCF valuation of the three railroads was performed by employing a two-stage model with a high growth period of 10 years. It should be noted that the assumed growth rate for the high growth period was calculated based on fundamentals. Therefore, these defer from average analyst expectations which are generous in my opinion. The major inputs and the valuation results are presented below.

CNI

CP

NSC

Bottom-Up Beta

1.16

1.31

1.13

Equity Risk Premium

5.3%

5.3%

5.3%

Cost of Equity

8.65%

9.44%

8.49%

Average Growth Rate (Years 1-5)

8.82%

10%

9.08%

Average Growth Rate (Years 6-10)

5.02%

5.5%

5.13%

Stable Growth Rate

2.5%

2.5%

2.5%

Valuation

Present Value of FCFE in High Growth Period (Billions)

$12.95

$3.43

$5.85

Present Value of Terminal Value of Equity (Billions)

$25,81

$6.67

$15.35

Cash, Marketable Assets and Non-Operating Assets (Billions)

$0.89

$0.37

$1.06

Total Equity Value (Billions)

$39.66

$10.48

$22.26

Market Value of Equity/Share

$85.23

$62.17

$60.41

Summary

Taking the average of the fair values obtained from the previous sections, fair value for the six companies is calculated. The results are shown in the table that follows.

CNI

CP

NSC

Relative Valuation Based

$65.51

$55.82

$67.52

DCF Based

$85.23

$62.17

$60.41

Fair Value

$75.37

$59.00

$63.97

Current Stock Price

$67.15

$65.43

$62.10

% Discount

12%

-10%

3%

Based on the performed analysis, I would buy shares CNI, hold shares of NSC and sell shares of CP.

(Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision.)

Disclosure: No positions. I plan on opening a position in CNI if and when it trades below $60/share resulting in a total return potential of 20% based on the $75 fair value

Source: Railroad Stocks: Determining Fair Value